Europe Bans Short Sells, But Will It Work?

France, Spain, Belgium and Italy decided to ban short selling on some stocks for two weeks.

"Some authorities have decided to impose or extend existing short-selling bans in their respective countries," the European Securities and Markets Authority said in a statement. "They have done so either to restrict the benefits that can be achieved from spreading false rumors or to achieve a regulatory level playing field, given the close inter-linkage between some EU markets."

Banning short sells is something that the U.S., France, Germany and the U.K. did during the market turmoil of Sept. 2008. Christopher Cox, the former chairman of the Securities and Exchange Commission, reasoned at the time that the bans were necessary so investors knew the information they were getting about stocks was accurate.

But does banning short settle rattled markets?

First let's back up a bit. Let's look to Al Jazeera, which put together a very short, but easy to understand video explaining what a naked short sell is:

Essentially a short seller borrows stock from someone for a fee, let's say $1. At the time, let's say, a short seller borrows $100 worth of stock. They sell it and hope it drops. Let's say in the next 24 hours, it does indeed drop to $80. They buy new stocks and give them back to whom they lent them from. And suddenly they've just made $19, after they pay back the fee.

As you heard in the video, the problem with short selling, some people think, is that it encourages speculation and if hundreds or thousands are doing the same thing, it is a self fulling prophecy.

Financial historians warned that the bans in 2008 did not work and that such measures were often driven more by political concerns — the need to display some form of decisive action — than by proved market theories.

"The short-sale ban really smacks of desperation," said Kenneth S. Rogoff, a professor of economics at Harvard. "That's their plan for solving the euro debt crisis? I mean, this isn't going to buy them much time."

Two European economists, Alessandro Beber and Marco Pagano, looked at short selling bans from 2007 to 2009. Their research looked at bans on more than 5,000 stocks in 19 countries after the financial crisis and found that it did not make a difference:

The evidence in this paper suggests that the the knee-jerk reaction of most stock exchange regulators around the globe to the financial crisis – imposing bans or regulatory constraints on short-selling – has been detrimental for market liquidity and price discovery, and at best neutral in its effects on stock prices. The ban-induced decrease of market liquidity is especially serious because it came at a time when bid-ask spreads were already high as a result of the crisis and investors were desperately seeking liquid security markets due to the freeze of many fixed income markets.

Cox, the former U.S. securities regulator who instituted the ban on short sales in the U.S. during the 2008 financial crisis, said in December of that year that he regretted doing so.

"While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again," Cox told Reuters in a telephone interview from the SEC's Los Angeles office late on Tuesday. "The costs appear to outweigh the benefits."

Less liquidity in the markets was one of the unintended consequences, experts have said.

The SEC imposed the temporary ban under intense pressure from the Federal Reserve and Treasury Department which insisted it was crucial to the short-term survival of these institutions, Cox said.